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Can the sector sustain its winning streak?

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1 day ago

September 18, 2024

Can the sector sustain its winning streak?

While big tech has stolen the headlines, big energy has been the real winner of the past three years.

Russia’s invasion of Ukraine, instability in the Middle East and longer-term factors related to the energy transition have pushed prices higher, creating a strong environment for energy companies. So, what’s next for the sector?

The MSCI World Energy index has risen by an average of 24.3% each year for the past three years, compared to just 13% for the MSCI World Information Technology index and 6.9% for the MSCI World index.

Although the Middle East looks increasingly unstable, which could threaten the oil supply, the oil price has not responded

The strongest beneficiaries remain the oil and gas giants – Exxon Mobil, Chevron, Shell and BP — which comprise around 40% of the index between them.

There is a question over whether the sector can sustain this growth. While geopolitical crises are ongoing, the world’s commodity markets appear to have adjusted. Although the Middle East looks increasingly unstable, which could threaten the oil supply, the oil price has not responded.

Weak demand from China amid a broader economic slowdown has kept the price low. Fears over weakness in the US economy have also depressed prices.

There are also broader considerations around the energy transition. The oil and gas sector has been seen as difficult from an ESG point of view. While some oil and gas companies are undoubtedly moving towards renewables, the overall picture is weak.

A report in November 2023 found oil and gas majors were putting just 3% of their investments into renewables

An International Energy Agency (IEA) report in November 2023 found oil and gas majors were putting just 3% of their investments into renewables. Equally, while short-term demand for oil and gas remains robust, it is likely to decline over time.

The same IEA report said: “Even with current policy settings, global demand for oil and gas is expected to peak by 2030. However, under more robust climate change measures, demand could plummet by 45% below today’s levels by 2050.”

It said that to achieve net-zero emissions by mid-century and limit global warming to 1.5C, the industry must prepare for a decline of more than 75% in oil and gas use by 2050.

Peter Michaelis, head of sustainable investment at Liontrust and a manager on the Liontrust Sustainable Future Global Growth fund, points out the “era of burning hydrocarbons for energy is coming to an end.”

It is naïve to invest in the incumbent oil, coal and gas industries, given they are going to struggle to compete economically

He added: “It is naïve to invest in the incumbent oil, coal and gas industries, given they are going to struggle to compete economically as well as being diametrically opposed to the aim of a drastic reduction in carbon emissions.”

Certainly, it is difficult to slot oil and gas companies into an ESG framework. Companies such as TotalEnergies may be an exception. It is putting around one-third of its investments into renewable energy and is a popular choice for fund managers who want to keep their sustainability credentials intact, while also taking exposure to the sector.

Nevertheless, there are those who argue there is a place for oil and gas companies in a portfolio. They certainly have a role in dividend payments. Oil, gas and energy companies contributed around £2.9bn to the total of UK dividends in the second quarter of 2024, with Shell and BP consistently among the top 10 dividend payers in the UK market.

Equally, oil and gas companies are still an important part of some major indices, particularly in the UK, which makes them hard to ignore. They are 11% of the FTSE All Share, for example. However, it is also worth noting they are only 4.3% of the MSCI World index, which makes the sector less relevant on a global stage.

Oil, gas and energy companies contributed around £2.9bn to the total of UK dividends in the second quarter of 2024

They will still appear sporadically in fund manager portfolios, particularly UK managers with a value or contrarian tilt. Schroder Income, for example, has Shell as its second largest holding, though is underweight the energy sector overall. Artemis Income also has a significant weighting in BP, although it is also underweight the sector.

Those who still like the sector will argue it is cheap and generates significant cash flow. Deloitte research predicts the sector will generate $800bn in free cash flow in 2024.

Capital spending is still constrained, which means cash is likely to come back to shareholders in the form of dividends and buybacks. In 2023, the big five oil majors – BP, Shell, Chevron, TotalEnergies and ExxonMobil – returned $104bn to shareholders in dividends and buybacks.

Investors don’t need to pay high prices. The MSCI World Energy index trades at a price to earnings ratio of 11.8x, compared to 22.1x for the MSCI World index.

The sector be a source of dividends, it can help investors lean into economic growth and it can provide a hedge against geopolitical disruption

This may be a double-edged sword. There is a concern these high cash flows may draw the attention of cash-strapped governments that need funding for the energy transition. In the UK, the Labour government has said it plans to raise just over £6bn across the next parliament through increasing and extending the Energy Profits Levy.

Originally a ‘windfall’ tax on the profits of oil and gas companies, this will continue even though the ‘supernormal’ profits from high oil and gas prices are now in the past.

The energy sector can still play a number of roles in a portfolio: it can be a source of dividends, it can help investors lean into economic growth, and it can provide a hedge against geopolitical disruption.

However, it also comes with significant risks and is a tough sell from an ESG point of view. Investors will have to decide whether they are sufficiently compensated for the risks involved.

Darius McDermott is managing director of Chelsea Financial Services and FundCalibre

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